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1. European Central Bank’s Monetary Policy
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1. Introduction
“A common monetary policy in the euro zone countries is a novelty. In the
past, the German Bundesbank determined monetary developments in most
of Europe. Policy decisions were mainly based on the economic situation in
Germany. In contrast, in striving for its objective of price stability the
European Central Bank has to take the economic situation in the entire
‘euroland’ into account. How this should be done – that is, which strategy
the ECB should follow – was discussed extensively before the monetary
union started. However, no consensus was reached. The European Monetary
Institute summarized the options (mainly inflation targeting and monetary
targeting) and it was left to the ECB to decide upon its strategy”
1
.
In October 1998 the Governing Council of the ECB announced its monetary
policy strategy, designed to achieve the mandate assigned by the Maastricht
Treaty. One of the two central principles
2
established by the Treaty is the
central role of price stability, which is the primary objective of the ECB’s
monetary policy. Marco Buti and André Sapir maintain that the fact that
price stability is the primary objective, means that ECB’s main goal is to
assure a low and stable inflation rate.
1
Sylvester C. W. Eijffinger, Jakob de Haan, (2000), European Monetary and Fiscal Policy,
Oxford, Oxford University press p.54.
2
According to Marco Buti and André Sapir (1999), the Maastricht Treaty establishes two
central principles for the ECB. One concerns the relevance of price stability as the primary
objective of the European monetary policy. The second is the ECB independence. “The
concept of independence of ECB is related to the autonomy of decision making in regards
to governments, parliaments and all decisional organisms at European and national levels.
According to the Treaty, in accomplishing the monetary policy, the ECB policy making
organisms cannot take orders or follow instructions from any of the mentioned organisms.
At the same time, the Treaty requires that these organisms respect ECB independence in
order to prevent them from interfering with European monetary policy. The independence
principle fulfils the task of protecting ECB from political pressures and allows the ECB to
accomplish its goals with a long run perspective”. p. 79
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However, the Treaty does not specify the operative contents of price
stability in a specific way; these are left to ECB’s decisions. The economic
principle at the core of the price stability objective is based on the fact that
price stability contributes utmostly to the allocation of production factors,
fostering in this way a sustainable economic growth and a high occupation
level.
As underlined in by the ECB in January 1999 Monthly Bulletin, in order to
fulfil the aim of price stability, the Eurosystem
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monetary policy strategy
must meet certain general criteria.
“Foremost among these criteria is the principle of effectiveness. The best
monetary policy strategy for the Eurosystem is the one which best ensures
the achievement of, and signals a credible and realistic commitment to, the
primary objective of price stability”
4
. Thus, a monetary policy strategy must
be reliable to be effective. In other words, both the public and the financial
markets, must be persuaded that the Governing Council of the ECB is
committed to maintaining price stability, has the instruments and the
capability to do so, and is implementing monetary policy with this objective
in mind.
Moreover, the Eurosystem’s monetary policy strategy has to satisfy a
number of other criteria in order to reach its goal:
3
The Eurosystem comprises the ECB and the National Central Banks (NCB) of the
Member States which have adopted the euro in Stage Three of Economic and Monetary
Union (EMU). There are currently 12 NCBs in the Eurosystem. “If and when all 15
Member States participate in the euro area, the term “Eurosystem” will become a synonym
for the ESCB (European System of Central Banks). The Eurosystem is governed by the
Governing Council and the Executive Board of the ECB.” (ECB Monthly bulletin, January
1999, p.7) The Governing Council comprises all the members of the Executive Board and
the governors of the NCBs of the Member States which have adopted the euro. The
Executive Board comprises the President, the Vice-President and four other members
appointed by the Heads of State or Government of the Member States which have adopted
the euro.
4
ECB,( January 1999) , The stability-oriented monetary policy strategy of the Eurosystem,
Monthly Bulletin, p.44.
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ξ The strategy must be clear and understandable. If there is ambiguity about
the objective of monetary policy or how this objective will be achieved,
unnecessary uncertainty will be created in the minds of the public.
ξ Furthermore, the strategy must be transparent. The public must be
presented ex ante with information about how monetary policy decisions
are being made by the Governing Council and the economic rationale on
which they are based.
ξ The strategy must ensure that the Eurosystem is accountable both for its
policy actions and for its performance in achieving the primary objective of
price stability. In the view of the Governing Council, this entails the
publication of a quantified objective against which the public can sensibly
judge the performance of the Eurosystem and its single monetary policy.
ξ Finally, the strategy must be consistent with the Eurosystem’s institutional
independence.
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Having considered various options on the basis of the criteria outlined
above, the Governing Council of the ECB announced the Eurosystem’s
stability-oriented monetary policy strategy to guide its monetary policy
decisions on 13th October 1998.
The strategy consists of a quantitative definition of the objective of price
stability and a framework - the so called “two pillars”- within which the
forward-looking assessment of the economic situation can be analysed and
undertaken.
The first pillar assigns a prominent role to money, including the
announcement of reference value for monetary growth. This reflects the
monetary origins of inflation over the medium to long term. Under the
second pillar of the monetary policy strategy, the Governing Council
regularly monitors and analyses a wide range of other economic and
financial indicators which affect price developments over the short to
medium term.
5
ibid.
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Another fundamental aspect of the ECB’s monetary policy is that it aims to
pursue price stability over the medium term. “This means that the ECB
recognises that monetary policy cannot, and therefore, should not, attempt to
fine-tune price developments at short horizons”.
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In fact, as it will be
explained later in this chapter, the economy is continuously subject to
unforeseeable shocks which may affect price developments. At the same
time, monetary policy can only affect price developments with significant
time-lag. “Therefore, it would be impossible for any central bank to keep
inflation at a specific point target at all times or even to bring it back to a
desired level in a very short time. Instead, monetary policy needs to act in a
forward-looking manner and can only maintain price stability over longer
periods of time. This is the core of the ECB’s medium-term orientation”.
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6
ECB, (June 2003), The outcome of the ECB’s evaluation of its monetary policy strategy,
Monthly Bulletin, p.80.
7
ibid,p.82.
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2. Focusing on price stability
“Central Bankers and most economists view price stability as a worthy
objective since they believe inflation to be costly. Some of this costs involve
the average rate of inflation, while others relate to the variability and
uncertainty of inflation”.
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Expected inflation can affect the allocation of the economy’s resources in
three main ways. First, as Sylvester Eijffinger and Jakob De Haan pointed
out, inflation places a tax on money balances when those balances pay less
than the market rate of interest. Consumers and businesses will make more
trips to the bank to avoid holding significant amount of currency. These
costs are referred to as shoe leather costs. “The ‘shoe-leather’ costs incurred
in the attempt to economise on the use of money as a medium of exchange.
When inflation increases the opportunity cost of holding money, measured
by increases in the nominal interest rate, people seek to minimise cash
holdings by making more frequent trips to the bank. Such trips inevitably
involve time and effort and, of course, add to the wear on one’s shoes”.
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“A second cost arises because many tax systems are defined in nominal
terms. As a result higher nominal incomes which are only due to inflation
can lead to a higher tax burden relative to income (bracket creep).
A third cost of expected inflation are so-called menu costs, or costs to firm
of changing prices (reprinting price lists, informing customers, and so
on)”.
10
8
Eijffinger, S., De Haan, J., (2000), p.55.
9
Editors Alicia García Herrero, Vítor Gaspar, Lex Hoogduin, Julian Morgan, Bernhard
Winkler, (2001), Why Price Stability? -First ECB Central Banking Conference, Frankfurt,
ECB’s other publications, p8.
10
Eijffinger,S., De Haan,J. (2000), p.55.
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Eijffinger and De Haan focus not only on the importance of expected
inflation but on the consequences of unexpected inflation too. An important
consequence of unexpected inflation is the redistribution of wealth which
may be significant and is always arbitrary. Higher inflation leads also to
more inflation uncertainty. Uncertainty on inflation can introduce further
costs: it may lead to a “[…] risk premium in interest rates, possibly lowering
investment. Furthermore, it may undermine the functioning of markets. In a
market economy, households and business base their decisions on prices of
goods and assets. In other words, prices are signals upon which the resource
allocation is based. […] Empirical evidence suggests that the benefits of
price stability for economic growth are significant. Several studies conclude
that countries with lower inflation appear, on average, to grow more
rapidly”.
11
11
ibid. p.56.
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3. The advantages of maintaining price stability
As stated by the European Central Bank in several documents,
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price
stability avoids distortions and helps to ensure that the market will allocate
real resources efficiently by improving the transparency of the relative price
mechanism. A more efficient allocation will raise the productive potential
of the economy. In this sense, price stability creates an environment in
which the necessary structural reforms implemented by national
governments to increase the flexibility and efficiency of markets can be
most effective. Secondly, as stable prices minimise the inflation risk
premium in long-term interest rates, they lower long-term rates and help to
stimulate investment and growth.
Moreover, if the future price level is uncertain, real resources are diverted to
hedging against inflation or deflation, rather than being put to productive
use. Credibly maintaining price stability avoids these costs and provides the
environment for efficient real investment decisions. Price stability also
eliminates the real costs entailed when inflation or deflation increases the
distortionary effects of the tax and welfare system on economic behaviour.
Finally, price stability helps maintain social cohesion and stability thanks to
the fact that it avoids large and arbitrary redistribution of wealth and
incomes that arises in inflationary as well as deflationary environments.
These arguments collectively suggest that maintaining price stability in
itself contributes to the achievement of output or employment goals.
12
See ECB, (January 1999), “The stability-oriented monetary policy strategy of the
Eurosystem” , Monthly Bulletin; ECB (October 2001),“Issues related to monetary policy
rules”, Monthly Bulletin; ECB, (May 1999),“The operational framework of the
Eurosystem: description and first assessment”, Monthly Bulletin.
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The logic underlying both the Treaty and the Eurosystem’s stability oriented
monetary policy strategy is therefore that output and employment goals are
best served by a monetary policy that focuses on price stability.
In addition, the empirical evidence strongly suggests that the benefits of
price stability for real economic performance are vital. Several studies have
shown that, across a large number of countries, nations with lower inflation
appear, on average, to grow more rapidly
13
.
13
See Robert J. Barro(1997) in Determinants of economic growth, MIT Press, and Martin
S. Feldstein, (1999), Costs and benefits of price stability, Chicago, Chicago University
Press.
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4. The Primary objective of the single monetary policy: price
stability
The Treaty - Article 105 (1)- states that “the primary objective of the
ESCB
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shall be to maintain price stability” and that, “without prejudice to
the objective of price stability, the ESCB shall support the general economic
policies in the Community with a view to contributing to the achievement of
the objectives of the Community as laid down in Article 2”.
Article 2 of the Treaty mentions as objectives of the Community, inter alia,
“a high level of employment […], sustainable and non-inflationary growth,
a high degree of competitiveness and convergence of economic
performance”. Therefore, the Treaty recognises the need for the ECB to
pursue other objectives, and even though “[…] la BCE è obbligata a fornire
il proprio sostegno alle politiche economiche generali della UE, come un
elevato tasso di crescita, l’occupazione e la protezione sociale”
15
,“these
objectives are seen as secondary, i.e. they should not interfere with the
primary objective of price stability.”
16
By focusing the monetary policy of the ECB on this primary objective, the
Treaty makes it clear that ensuring price stability is the most important
contribution that monetary policy can make to achieving a favourable
economic environment and a high level of employment.
14
The European System of Central Banks (ESCB) comprises the ECB and the national
central banks (NCBs) of all EU member States. NCBs of the EU Member States which
have not adopted the euro (Denmark, Sweden, the United Kingdom) are part of the ESCB
but do not participate in monetary policy decision-making for the euro area. For this reason,
the decision-making bodies of the ECB have chosen the term ‘Eurosystem’ to describe the
arrangement whereby the ECB and NCBs of participating Member States carry out the
tasks of the ESCB within the Euro Area.
15
Marco Buti, André Sapir, (1999), “La politica economica nell’Unione economica e
monetaria europea”, Bologna, Il Mulino, p. 79.
16
Paul De Grauwe, (2000), Economics of Monetary Union, Oxford, Oxford University
Press, p.151.
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Box 1:The Eurosystem’s mandate: Key excerpts from the Treaty
Article 105 (1)
The primary objective of the ESCB shall be to maintain price stability. Without
prejudice to the objective of price stability, the ESCB shall support the general
economic policies in the Community with a view to contributing to the objectives
of the Community as laid down in Article 2.
Article 2
The Community shall have as its task … to promote throughout the Community a
harmonious and balanced development of economic activities, sustainable and non-
inflationary growth respecting the environment, a high degree of convergence of
economic performance, a high level of employment and of social protection, the
raising of the standard of living and quality of life, and economic and social
cohesion and solidarity among Member States.
Article 3a
For the purposes set out in Article 2, the activities of the Member States and the
Community shall include …the definition and conduct of a single monetary policy
and exchange-rate policy the primary objective of both of which shall be to
maintain price stability and, without prejudice to this objective, to support the
general economic policies in the Community.
Source: ECB monthly bulletin, January 1999
Although it clearly establishes the maintenance of price stability as the
primary objective of the ECB, the Treaty does not give a precise
definition of what is meant by price stability.
In 1998, in order to identify this objective more precisely, the Governing
Council of the ECB announced the following quantitative definition as a key
element of its monetary strategy: “Price stability shall be defined as a year-
on-year increase in the Harmonised Index of Consumer Prices (HICP) for
the euro area of below 2%”.
17
17
ECB press release ,“A stability-oriented monetary policy for the ESCB”, 13th October
1998.
12
As described in the document released by the Commission of European
Communities (2000) the HICP is “[…] a price index that is based on the
prices of goods and services available for purchase in the economic territory
of the Member States for the purpose of directly satisfying consumer
needs”. The Commission of European Communities further explains that “
the HICP is not a cost of living index. That is, it is not a measure of the
change in the minimum cost for achieving the same ‘standard of living’
from two different consumption patterns realised in the two periods
compared and where factors other than pure price changes may enter the
index”.
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On the whole, the HICP is a comprehensive measure for inflation,
“[…]reflecting the focus of the general public on consumer goods”.
19
The definition of price stability adopted by the ECB has been constantly
criticised by some authors who maintain that, while it provides a ceiling for
inflation in the Eurozone, it does not specify a floor. According to Svensson
(2002)
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, the ECB’s definition of price stability, is “ambiguous and
asymmetric and therefore less effective as an anchor for inflation
expectations”. Moreover,“[…] the threat of deflation is not ruled out, at least
if one bases oneself solemnly on the Treaty. However, the TEU does
mention a price increase, which in principle should rule out deflation.
Notwithstanding, the inexistence of a clear floor for inflation may also raise
transparency related questions and create some uncertainty in economic
agents”.
21
18
Commission of the European Communities,(2000), On the Harmonisation of Consumer
Price Indices in the European Union. Report from the Commission to the Council. COM
(2000) 742 final. Brussels: European Commission.
19
Eijffinger, De Haan, (2000), p.61.
20
Svensson, Lars “A good thing could happen at the ECB: An improvement of the
Eurosystem’s definition of price stability”, September 2002.
21
Hugo Zsolt De Sousa, (2003), “The ECB and Monetary Policy”, Notre Europe, policy
paper Nº3, p.3.
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